The debt market could get ugly

A
make-up artist works on a face at the 40th annual
Comic-Con.Mike
Blake/Reuters

Things haven't been pretty for energy companies that have a lot
of debt. Low oil prices have pressured profits and led to
skyrocketing defaults and an ugly state of affairs for energy
debt.

The tough times in the debt market won't be limited to just the
energy sector for long, according to Adam Richmond and the US
credit strategy team at Morgan Stanley.

"While many believe the problems in credit are predominantly
energy-related, and thus possibly behind us, we think the
fundamental weakness in energy over the past year is just a
symptom of the bigger issue," Richmond wrote in a note to
clients.

"Low rates and easy liquidity for years (as well as minimal
earnings growth) have driven significant increases in leverage
and deteriorating credit quality almost everywhere."

Richmond cites two interconnected reasons for the
coming increase in defaults: historically low interest rates
and the booming growth of low-quality debt issuance.

Richmond broke down the growth of the overall amount of debt
issued by companies and the percentage of total high-yield debt
issued by firms with equity-to-debt leverage of six times or more
in various sectors. He refers to this as the leveraged "tail" in
each sector.

Despite strong incomes from consumers and
increased spending, Richmond said that the debt taken on by
consumer-focused companies is concerning.

"Ex-commodities, we see heightened risks in consumer cyclicals as
an example, which accounts for 18% of the growth in the
[high-yield] bond market in this cycle, and has experienced a
large increase in the 'highly leveraged tail' since 2011 (in
absolute terms)," he wrote.

"Similarly, 27% of the 'tail' in the loan universe is made up of
consumer cyclical companies."

Healthcare is in similar straits, according to Richmond.

"Outside of commodities and consumer cyclicals, healthcare
accounts for the largest absolute and relative amount of the tail
($51 billion and 59% of sector)," Richmond wrote.

The biggest problem, however, is that while these sectors are
most at risk, the entire market has seen a boom in highly levered
companies issuing debt. In fact, the amount of debt from
companies with six times leverage or worse has doubled in the
past five years — a $215 billion increase.

This increase in credit from companies with less ability to pay
back their debts would quite possibly lead to an ugly market for
every group of firms. The three sectors Richmond identified could
get there sooner and fall harder.